Sunday, August 27, 2023

Economics: Federal Reserve - Move Fast And Break Things


 (Drivebycuriosity) - Last Friday Federal Reserve Chairman Powell gave his usual Jackson Hole speech. As feared Powell called inflation too high and warned that the Fed is prepared to raise rate further ( cnbc). Powell´s message reminds me of Mark Zuckerberg`s famous motto: "Move fast and break things" (hbr.org ). 

The announcement sounds outrageous. The Fed had already lifted her interest rates at a breath taking speed to 5.25 to 5.5 percent from near zero in March 2022. On the financial markets the interest rates for bonds, mortgages & credit cards followed.



 ( source )

I strongly believe that inflation is already defeated and the Fed is overshooting.

 

                      Helicopter Money

The high inflation rates of the recent months were caused by a flood of money in the past. In 2020/21 the US government - supported by massive bond purchases by the Federal Reserve -  flooded the US economy with trillions of dollars, giving the Americans enormous purchasing power. Friedman called this action prophetically helicopter money (cato ). The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & liquid deposits at banks).

As a result in 2020 & 2021 the US money supply M2, the engine of the inflation, jumped 40% (image below). The money deluge met a constraint supply of goods & services, partly because of COVID-19 which disturbed the supply chains.  

"Inflation is caused by too much money chasing too few goods and services", notice the economists at fisherinvestments. "It is no surprise that prices increased so much", comments Tyler Cowen, Professor at George Mason University (marginalrevolution).

 


 (source )

                            Causal Connection

The causal connection between money and inflation is known since the 16th century at least. Nicolaus Copernicus described already in the year 1522 how "too much money" causes inflation. Copernicus` "quantity theory of money" is based on observations: 

Early in the 16th century Spain conquered today`s Latin America and looted the silver stocks. The Spaniards send the precious metal to Europe where is was printed into coins and used as money. 

As a result the European money supply jumped. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level. 

Elaborated studies by Milton Friedman, Karl Brunner, Allan Meltzer and many other economists (known as Monetarists) described already in the 1960s how and why the inflation rate follows the growth rate of money with a time lag (causal connection).

The  monetary growth already peaked in February 2021 (with plus 27%). Since then the monetary growth rates have been falling and turned negative in December 2022. In the recent months the money volume has been shrinking! In July M2 dropped 3.5% YoY ( fred.stlouisfed).

 


 (source )

 

                   Monetarist Playbook

As a result inflation peaked in June 2022 with 9.1% and dropped to 3.3% in July, following the pull of the shrinking money supply.

The Fed does not only ignore the cause of the recent inflation wave, Powell & Co. also follow an outdated inflation definition and focus on the so-called Core PCE price inflation (plus 4.1% YoY source ). 

The Core Inflation excludes energy costs & food prices and focuses on shelter, a mix of rents & house prices which counts for 42% of the core-inflation (americanprogress fisher)

 


 ( source )

Unfortunately the shelter component does not show current house prices. Instead it has a time lag of 12-18 months ( aier). As a result the Fed is way behind the curve and might already overshoot.


The collapse of the inflation rates follows the monetarist playbook and proves the Fed wrong. It is highly likely that the recent interest rate hikes are driving inflation rates further south. Inflation might even turn into deflation - following the shrinking money volume (negative growth rates). The Fed`s stubborness could lead to deflation and might even start a new recession. Move fast and break things! 

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